Audience:
High school, advanced placement and college economics students

Time
required:
About 50 minutes of class time.

Summary:
This classroom simulation illustrates some basic principles of
international finance. Students are grouped into four
countries, which are endowed with goods (candy), stock, and
domestic currencies. During a brief trading session,
students can use their currency to buy domestic goods and assets,
or they can convert it into foreign exchange and buy foreign goods
and assets. When the trading session ends, students use
tables to record each country’s net exports, net foreign
investment, foreign exchange transactions, and balances on current
and capital accounts. The tables demonstrate that net
exports and net foreign investment are equal, and show the
relationship between a country’s current account and capital
account balances. The four-country simulation described in
this article is designed for classes of 17 to 73 students, but the
number of countries can be decreased or increased to accommodate
smaller or larger classes.

Resources

:

Click here to download
the materials for the simulation in pdf format. The
materials include masters of a student handout, fake currency
notes, and fake stock certificates.

25 copies of fake currency notes for each of four
countries, denominated so that each country’s note is worth
$1. Examples of fake currency for the United States, Britain, Japan, and Mexico are
provided, and are based on exchange rates of $1 = £.6 =
¥120 = MXN 10. (As exchange rates change over time, you
may want to update the denominations of the fake currencies.)

25 pieces of each of four different kinds of candy.
Individually wrapped Halloween candy works well.

6 stock certificates for each of the four candy firms.
To minimize confusion between currency and stock certificates,
it helps to print one or the other on colored paper.

Copies of the student handout.

An overhead projector and transparencies of the tables
in the student handout.

Procedure:

Begin by
giving each student a copy of the student handout. Appoint a capable student to serve as a foreign
exchange broker, and give him or her 10 bills from each of the
four countries and a desk at the front of the classroom.
Divide the remaining students into 4 countries, appoint a leader
for each country, then give each leader a packet containing 15
bills of currency, 5 stock certificates, and 10 pieces of candy.
Ask each of the leaders to appoint a stockbroker, who will sell
stock, and a candy retailer, who will sell candy.
Announce that all the other students in each country will serve as
households, and that they will be buying stock and candy.
(Let the leaders also serve as households in small classes,
otherwise have them sit out.) Have the leaders give the
stock certificates to the stockbrokers, the candy to the
retailers, and then divide the currency as evenly as possible
among the households.

Read aloud the
rules listed in the handout, and then ask each leader to tell the
class about the candy and stock available in his or her country,
and the currency used. Emphasize that just as
households in the real world use all of their disposable income to
consume or save, households in this simulation must spend all of
their currency on either candy (representing consumption) or
stocks (representing saving). Allow the trading to proceed
for about 5 to 10 minutes, until all of the currency has been
spent and all of the candy and stock has been sold.
You may need to help the last few buyers and sellers find each
other. When the trading ends, ask the leaders to count all
of the currency, stock certificates, and candy in their countries.
Have them report these amounts to you and record them on a
transparency of Table 2.

Before
proceeding, check the accuracy of the numbers. Each country
should end up with 15 domestic currency notes, one for each of the
candies and stock certificates it sold. Each of the
rows should also add up to 30, since each country was initially
endowed with, and should have ended up with, 30 tradable items in
the form of currency, stock certificates, and candy. I’ve
found that discrepancies sometimes occur, and that they’re
usually caused by misplaced or miscounted stock certificates or
candy, or by illegal “two-for-one” trades. It’s
usually easy to discover and correct these problems. Indeed,
doing so enhances the lesson in that it illustrates how economists
can pinpoint statistical discrepancies that show up in
international accounts because of reporting errors and illegal
flows of money over borders.

If you can’t
quickly track down the source of the discrepancy, go to the
leader’s desk and adjust that country’s holdings using, if
necessary, extra currency, stock, or candy so that each of the
rows sums to 30 and the three middle columns sum to 60, 20 and 40
respectively. Don’t bother figuring out whether the
stock or candy you need to add or subtract should be foreign or
domestic—it won’t significantly affect the outcome.
After you’ve done that, fix the numbers in the table
accordingly.

Once Table 2
is in order, have students fill out the rows in Tables 3 and 4 for
their own countries, and then report the results to you.
Record each country’s results using transparencies and an
overhead projector, and instruct students to use that information
to completely fill out the two tables. At this point,
students will have enough information to complete Tables 5 and 6
on their own.

When the
tables are completed, ask your students to search for patterns and
relationships in them. Here are some of the
observations they should make:

The sum of the current account balances of all of the
countries in the world equals zero. Another way of
expressing this is that the sum of net exports in the world
equals zero. To help students understand why this is
true, ask them to imagine a world with only two countries.
If one country is exporting more than it’s importing, the
other must be importing more than it’s exporting.

Net exports and net foreign investment are equal for
each country. Japan’s net
foreign investment, for example, represents the difference
between the foreign assets that are acquired by Japanese
residents minus the Japanese assets that are acquired by
foreign residents. Japan’s positive
net foreign investment serves as compensation for the
sacrifice of having positive net exports—that is, of
producing more than it’s consuming.

Surpluses and deficits in any country’s current
account are offset by corresponding deficits and surpluses in
the capital account. In the simulation, households
in a country pay for imports either by exporting goods or by
exporting assets. If a country imports more goods than
it’s exporting, then it must compensate by exporting more
assets than it’s importing. In doing so, it runs a
current account deficit and an offsetting capital account
surplus. In the real world, it’s possible for a
country to run a balance of payment surplus or deficit, in
which the sum of its current account and capital account is
either positive or negative. But this can only occur if
the country’s central bank is buying or selling
international reserves. If the United States had a
balance of payments deficit, for example, it must be true that
the Fed is selling international reserves equal to that
deficit.

The capital account balances of all of the countries in
the world should sum to zero. This follows from
observations (1) and (3).

The quantity of currency supplied equals the quantity of
currency demanded for each country. In this experiment,
each market is forced into equilibrium by requiring that every
currency note be spent, and by matching the number of currency
notes to the amount of candy and stock certificates sold.
In the real world, however, exchange rates are often allowed
to rise or fall in order to equate the quantity of currency
supplied to quantity demanded.

Point out that
errors occur in the real world and that balance of payments
accounts always contain entries for statistical discrepancies,
which force the accounts into balance.

After you’ve
discussed these findings, allow the leaders to distribute the
candy and stock among the students in their countries. I
usually redeem the stock (for two pieces of candy each) at the end
of the class period, but you can, if you wish, wait until later in
the semester to do so.

Sample
Results

To illustrate
how this exercise works, the following completed tables show the
outcomes of a sample simulation. Actual simulations in my
classes have consistently yielded similar outcomes.

Table
1: Before Trade

Currency

(Number of
bills)

Stock

(Number of
certificates)

Candy

Row

totals

USA

15

5

10

30

Japan

15

5

10

30

Mexico

15

5

10

30

Britain

15

5

10

30

Column
totals

60

20

40

Table 2: After Trade

Currency

(Number
of bills)

Stock

(Number
of certificates)

Candy

Row

totals

USA

15

4

11

30

Japan

15

6

9

30

Mexico

15

7

8

30

Britain

15

3

12

30

Column
totals

60

20

40

Table 3: Net Exports

1.Domesticcandy
before trade

2.Domestic candy

after trade

3.

Exports

= (1) – (2)

4.

Imports

= Foreign candy purchased

5.Net exports = (3) – (4)

USA

10

3

7

8

-1

Japan

10

7

3

2

1

Mexico

10

4

6

4

2

Britain

10

5

5

7

-2

Table 4: Net foreign investment

1.

Domestic
stock before trade

2.

Domestic
stock after trade

3.

Foreign
purchases of domestic stock

=
(1) – (2)

4.

Domestic
purchases of foreign stock

5.

Net
foreign investment = (4) – (3)

USA

5

2

3

2

-1

Japan

5

1

4

5

1

Mexico

5

3

2

4

2

Britain

5

2

3

1

-2

Table 5: The Quantity of Currency
Supplied and Demanded

1.

Imports

2.

Domestic
purchases of foreign stock

3.

Quantity
of currency supplied=
(1) + (2)

4.

Exports

5.

Foreign
purchases of domestic stock

6.

Quantity
of Currency Demanded = (4) + (5)

USA

8

2

10

7

3

10

Japan

2

5

7

3

4

7

Mexico

4

4

8

6

2

8

Britain

7

1

8

5

3

8

Table 6: Balance of Payments

1.

Spending
flowing into country (excluding purchases of assets) =
exports

2.

Spending
flowing out of country (excluding purchases of assets) =
imports

3.

Balance
on current account =
(1) – (2)

4.

Spending
flowing into country for purchases of assets = foreign
purchases of domestic stock

5.

Spending
flowing out of country for purchases of foreign assets =
domestic purchases of foreign stock